Friday, February 11, 2011

The stimulus chicken race

I think that all of us who write here, and probably most visitors as well, are aware of the negative effects of the stimulus package passed by Obama.

In this post, I would like to bring to attention a largely forgotten aspect of the stimulus: The chicken race that follows

Let’s start with some basic economics: Countries trade with one another. Therefore, money that is spent in an american shop does not necessarily end up in America. If you buy a cell phone from Nokia, furniture from IKEA or maybe just a random pair of jeans, some of the money will end up outside America’s shores. Of course, this goes the other way around too.

So what is a chicken race? Many of you, especially fans of James Dean, may have heard of it. It is a game that was actually quite popular 50-60 years ago.

Two drivers drive their cars ttowards one another. If you swerve (in order not to crash), you are a chicken and you lose. If you both swerve, you are both chickens – the game ends in a tie and you are both humiliated (but at least you’re still alive). If you don’t swerve both your opponent does, you win. If none of you swerve, you will crash and probably die – this is the worst outcome (wikipedia has a more detailed description: http://en.wikipedia.org/wiki/Chicken_race)

You would think that swerving would be the most logical option, since the loss of swerwing (the humiliation of being a chicken) is much less than the loss associated with staying the course (death). However, if you assume your opponent is rational, then you know that he is going to swerve (since that’s the rational thing to do). And then, given that, it is in your interest to stay the course so that you actually win (why swerve and tie when you can stay the course and win?). And you opponent, unfortunately, thinks the same about you: He thinks that you are not so stupid that you would stay the course, and so he stays the course thinking he’ll win. And then, you both crash.

One of the revolutionary things about game theory is that it proves that the market isn’t always efficient and doesn’t always lead to the best outcome for society as a whole – Adam Smith had said (and I’m simplifying a bit now) that if everyone just does what’s good for themselves, we’ll all be better off. While that is correct in a lot of situations, John Nash showed that it’s far from true all the time. In a chicken race (if you have seen Rebel without a cause, you know what I mean), both drivers are better of swerving, but even if they agreed to swerve, they would both be too tempted to break this agreement because that would be better for themselves, given that the other player stuck to it.

So what does this have to do with stimulus? You see, this time around, this was largely avoided. But the next financial crisis may see this game theory dilemma develop: Everyone has to, or assume they have to, stimulate their economy but no-one wants to be the first (this is partly because stimulus/bailouts are unpopular)

A simple example: Imagine there are two countries which trade with each other. For simplicity, we’ll assume they got no other trading partners. Let’s call them country A and country B. Country A and B both gets into a financial crisis, and they both need to stimulate their economies (for the record, I’m against stimulus, but this would likely happen anyway). However, there is a problem: Stimulus tends to leak! This means that if Country A spends 100 billion on stimulus, 25 billion may very well end up in Country B. Supposing Country B is a lot smaller than A, they may only need 25 billion in stimulus. So instead of stimulating their economy themselves, they just wait for Country A to stimulate their economy, knowing that the stimulus will leak.

This isnt’ really fair though, is it? One country will see their problems fixed without having to increase their budget deficit or anything. With companies being multinational, this is a big problem: You may agree that a company needs a bailout, but you can’t agree on who should pay. Should Sweden be responsible for bailing out SAAB, or should the US be responsible (since SAAB was owned by GM which is an American company)? The Swedish government made a big deal about how they were not going to save SAAB, that they were fiscal conservatives and that they had not been elected to be car manufacturers, but to govern. But in secret, they were lobbying the American government to bail out SAAB instead so they wouldn’t have to. Their message was “No, we’re not elected to be car manufacturers… but we figured you are?”.

It is actually even worst. Let’s go back to our example, but now assume that Country B needs 50 billion of stimulus. What will they then do? They will of course only stimulate their economy by 25 billion, thinking the rest of it will be covered. Let’s say that Country B builds a financial model based on this, they only save 25 billion during the boom, thinking they won’t need more for the recession.

But what happens then if Country A refuses to bail out at all? What if they take a strict, fiscal conservative line? That will then hurt Country B as well. When the government increases the budget deficit, that increases the trade deficit as well. Here’s how it works: The government spends more. Some of the money will inevitably be spent on foreign goods. But just because the government spends on foreign goods (imports increase), doesn’t necessarily mean that foreigners will buy more goods from the country (so exports are likely to remain the same, at least for a long time). And so, the trade deficit goes up.

Country B will now have insufficient savings to bail out their industries, and will have to borrow money at an interest. If they hadn’t saved any money at all, they will now have to borrow more than they otherwise would have, and interest rates will be higher.They could make a mutual agreement to both stimulate their economy by a certain amount of money in the event of a stock market crash of course, but can they trust one another? Everyone would have something to win from breaking the agreement, and so it wouldn’t be a so called “nash equilibrium”.

What if no-one stimulates their economy? That will lead to a “crash” (as its called in a chicken race when no-one swerves) as the market falls much deeper than it would have if they would have both stimulated. Notice that this is in the short run, in the long run stimulus has some really nasty side-effects which is the reason why I don’t support it.

But if one country were to break the agreement and refuse to stimulate their economy, couldn’t the other country retaliate the next time the stock market crashes? The problem is that if they do that, they will be even worst off. If no-one stimulates their economy, that is a chicken race “crash”, the worst scenario that can happen. So you’d be better off keeping on swerwing (stimulating) even if the other player/country doesn’t.

This could also be described as a freerider’s dilemma, where smaller countries “freeride” on bigger countries stimulus.

So what will happen? Enter the EU into the equation. The EU, for those who don’t know this, has the ability to make laws that override the constitutions of its member countries. So technically, the EU could definitely make a law stating that small countries have to contribute to a stimulus package as well so that they cannot, like Sweden, try to freeride on the other countries’ efforts. But how do you decide how much each country should contribute to such an EU-wide stimulus package? The fact of the matter is that the big countries control the EU, and so I would imagine that smaller countries (think, Ireland, Sweden, Denmark) would be forced to pay an unproportionate amount of money. It wouldn’t be the first time the big countries ignore the plight of the small.

What will the next financial crisis look like? If things turn out this way, it will look just like a typical chicken race: The drivers (countries) will avoid swerving for as long as possible and try make the impression that they would rather crash than swerve (they will avoid a bailout/stimulus package for as long as possible, creating the impression they will never do one). In the end, it could go either way. An EU-wide stimulus seems to be the most likely option for Europe. A crash is not completely unlikely however.

A breakdown of various free trade agreements are also likely. In times of crisis, outsourcing becomes a lucrative option for companies looking to cut costs and gain the trust of investors. Free trade is good – there are no serious economists who would dispute that – but when a crisis strikes, and stimulus money meant to revive the economy flows overseas, protectionism is bound become more popular (remember the “Buy American” clause?) because of shortsightedness.

How can you prevent a chicken race? A great example would be doing something that stops you from swerving – if one player, just prior to the game, disabled the steering wheel in his car (so that he couldn’t swerve even if he wanted to), the other player would know that he had to swerve or their would be a crash, since his opponent couldn’t swerve.

What would the equivalent be in economic terms? I say a balanced budget agreement is the soution. That would make future bailouts and stimulus virtually impossible, since you always borrow money to finance these. You would “disable the wheel”, the possibility to “swerve”. And everyone could take that into account when making financial decisions – banks, other countries etc. Right now, the consensus seem to be that the stimulus of 2008-2009 where one-time events that should never be repeated. But frankly, no-one trusts the United States anymore in these matters. Your word is not good enough; it’s easy to say you’re not going to swerve before the race has begun, but it’s harder to stick to that when a crash is imminent.

Summary:

Every country has a short term gain in bailing out companies and stimulating their economies, however, they cannot keep their stimulus money to themselves because of trade with other countries, and would therefore rather not stimulate until they see what other countries are doing (that way, they can somewhat figure out how much stimulus their own economy will need). Everyone would gain from everyone stimulating, but no-one wants to be the first (everyone gains from both swerving in a chicken race, but the one who does it first loses). This is also because stimulus packages are impopular and can be dangerous for a politician’s career. Therefore, a crash may occur, even if it doesn’t maximize the outcome of the group ( a crash meaning no-one stimulates their economy, waiting for the other countries’ decisions, or no-one does it enough).

Note that I in no way support stimulus, but politicians take the fact that stimulus helps the economy as a given, and so f we want to figure out what they are going to do, we might just as well act as if that was really the case.

Please leave a comment and ask questions if anything is unclear. I’m a student of game theory (and finance/economics in general) as you may have figured out.